I believe stockmarkets are far from efficient. Correctly valuing a business is an extremely difficult problem that requires investors to predict the future and is lacking in clear sensible benchmarks. It is unsurprising that investors systematically and collectively get this valuation wrong in various ways. Markets are also affected by emotional swings, information problems and liquidity issues. The result is that many shares are mispriced and often dramatically so.
However, it is not straightforward to exploit this. This is partly because investors face the challenge of being unable to generate sufficient evidence to really know whether their strategy is performing well – ‘is my strategy doing well or am I just being lucky?’ On the one hand this makes things very difficult, but on the other hand it makes it easier for bad strategies and mispricings to persist, leaving more to play for. As a result I believe it is important to have clear logic behind a strategy and faith in it to weather the periods of underperformance that may arise. A strategy also needs to acknowledge the inevitability of mistakes and have a clear plan for dealing with them.
There are many ways to profitably exploit systematic mispricings and ‘beat the market’. My strategy is just one way and is focussed primarily on exploiting two particular factors in combination: a) the tendency for high quality defensive businesses to outperform over time and b) the tendency of shares with momentum to continue to do well.
So how have I arrived at this? My main source of inspiration is all the empirical evidence suggesting that factor investing works. In other words that shares with certain qualities (e.g. value, quality, momentum, small caps) tend to outperform the market over the long term. Over the past few years I have followed the outperformance of the ‘Stockranks’ developed on Stockopedia with great interest. My other inspiration is the great ‘value’ investor Warren Buffett who demonstrated that you could get phenominal returns from investing in high quality defensive shares over the long term. In the UK I have drawn from the approaches of Terry Smith, Neil Woodford and Nick Train, who all follow in this tradition.
There is empirical evidence that factors work better in combination with one another. Logically this makes a lot of sense – for example it is difficult to think about the ‘value’ of a share in isolation from its ‘quality’ – the two are part of a bigger whole. How best to combine factors is a challenge of limitless complexity. Stockopedia’s Stockranks suggest that a simple weighted index can work very well but I see this as a starting point rather than the only or best approach.
The backbone of my approach is to first consider the long term quality of shares independently of their prices and to screen out all potential investments unless they are very high quality. I then decide which of these to invest in at a given time on the basis of their current pricing, taking account of both valuation and momentum. To me this structure of investing makes better intuitive sense than combining all factors together in an index.
‘Quality’ is a broad concept and hard to define or measure. The underlying objective in assessing quality should be to roughly predict the business’s discounted and risk adjusted future cash return on investment. Luckily to do well you don’t need to do this in an absolute sense but can more simply identify which businesses are higher quality than others. This is possible with the easier question ‘does the business possess characteristics which make it more likely than other businesses to be able to compound (profitably reinvest) its profits over the long term to a greater extent?’
In practice quality factors are metrics or qualitative factors that can range from measures of a business’s balance sheet strength, its historic ability to generate and profitably reinvest cash and the quality of its management. Some of these factors are predictive of future profitability. However, they are often not of much value in isolation but need to be looked at collectively within a sensible framework. Qualitative assessment is an important supplement to looking at metrics, particularly as assessing quality is basically attempting to predict the future. To do this you need to have a view about things like whether a company has a competitive advantage that will endure and whether it is in a defensive growing market. The simple backwards looking metrics won’t tell you the whole story.
Why the highest quality is undervalued
To assess the valuation of a business properly you would need to account for quality by incorporating the compounding of future growth into the valuation. Traditional ‘value factors’ don’t do this. These measures, like the Price Earnings ratio, are pretty useless in isolation as they do not attempt to properly assess a share’s actual worth. A share’s worth is determined by what will happen to profits in the future, while these value measures look to the past. If you are buying a decent business that you expect to grow, i.e. the kind of business you should be buying, this is not so useful. Value metrics will treat a business with low costs and a highly valued product protected by IP the same as a business in a highly competitive market that is having to reinvest all of its profits just to stay afloat.
The overuse of these sorts of valuation metrics results in a huge pitfall or opportunity – it is very easy to underestimate the implications of future compound growth on present valuation. In most cases the best businesses will trade on apparently higher PE ratios relative to average businesses, but will still be relatively cheaper when you more carefully consider their likely profitability over the long term. This is because the best businesses will possess characteristics which will allow them to sustainably earn high profits and grow without needing to invest huge amounts, while average businesses will only at best be able to do so for shorter periods before competition is attracted or the business cycle turns. As a result the market tends to systematically undervalue high quality and defensive businesses.
This is part of the rationale for one of the key features of my approach – that I focus much more closely on identifying high quality than on thinking about valuation. I do this not because I think valuation is unimportant but because I believe the market is biased the other way. In particular, for the highest quality shares I believe market prices are in general too low in relation to their likely future compounded profits. As noted above, part of the reason for this is over reliance on short term historic value metrics. Another reason is that quality is fundamentally difficult to assess, particularly as it incorporates a lot of qualitative as well as quantitative factors that need to be thought about collectively. People often tend to focus unduly on what they can measure. I don’t have any great insights here and in fact am relatively new to this. My main guiding principle is to keep things simple but holistic – don’t lose sight of the big picture!
Momentum fits perfectly
The other complementary aspect of my strategy is to exploit share price momentum. In terms of factor investing I think momentum is the closest thing there is to a free lunch. Momentum arises for a very large number of compelling reasons to do with the underlying performance and characteristics of the business, investor behavioural biases, information issues and liquidity. Surprisingly, it can often be a good indicator that a share is undervalued. See my post on momentum to see why.
Momentum is easy to observe and to implement into a strategy so is a powerful tool in practice. Exploiting momentum involves buying shares that are rising in price and especially just after issuing positive news, or selling shares that are falling in price and especially just after issuing negative news. Run winners and sell losers! I think you’re missing a trick if you are a private investor who doesn’t incorporate momentum into your investing strategy in some form – the ability to exploit momentum well is one of the big advantages small investors have over larger institutions who suffer from holding large illiquid positions.
Exploiting momentum also is complementary to focussing on very high quality shares as these should tend to exhibit consistently rising prices over the longer term. Momentum, particularly over the longer term, can therefore be a useful indicator of quality in conjunction with other factors.
Another benefit of exploiting momentum is that it provides the discipline to deal with mistakes effectively. Identifying quality is hard. The only thing certain about the future is that I can’t predict it, so I want to have a strategy that is going to miminise losses from mistakes rather than lead me to anxiety and poor decision making. I don’t really want to experience the ‘value investor’s headache’ – ‘is the share price falling a good thing that means I should buy more or the sign of a terrible mistake?’